Here are a few jargons that we will look into –
1. Strike Price
2. Underlying Price
3. Exercising of an option contract
4. Option Expiry
5. Option Premium
Consider the strike price as the anchor price at which the two parties (buyer and seller) agree to enter into an options agreement. For all ‘Call’ options the strike price represents the price at which the stock can be bought on the expiry day. For example, if the buyer is willing to buy Tata Motors Call Option of Rs.180 (180 being the strike price) then it indicates that the buyer is willing to pay a premium today to buy the rights of ‘buying Tata motors at Rs.180 on expiry’. Needless to say he will buy Tata Motors at Rs. 180 only if Tata motors is trading above Rs.180.
As we know, a derivative contract derives its value from an underlying asset. The underlying price is the price at which the underlying asset trades in the spot market. For a call option, the underlying price has to increase for the buyer of the call option to benefit.
Exercising of an option contract
Exercising of an option contract is the act of claiming your right to buy the options contract at the end of the expiry. If you ever hear the line “exercise the option contract” in the context of a call option, it simply means that one is claiming the right to buy the stock at the agreed strike price. Clearly he or she would do it only if the stock is trading above the strike. Here is an important point to note – you can exercise the option only on the day of the expiry and not anytime before the expiry. Hence, assume with 15 days to expiry one buys FDC 260 Call option when FDC is trading at 230 in the spot market. Further assume, after he buys the 260 call option, the stock price increases to 290 the very next day. Under such a scenario, the option buyer cannot ask for a settlement (he cannot exercise) against the call option he holds. Settlement will happen only on the day of the expiry, based on the price the asset is trading in the spot market on the expiry day.
Similar to a futures contract, options contract also has expiry. In fact both equity futures and option contracts expire on the last Thursday of every month. Just like futures contracts, option contracts also have the concept of current month, mid month, and far month.
Premium is the money required to be paid by the option buyer to the option seller/writer. Against the payment of premium, the option buyer buys the right to exercise his desire to buy (or sell in case of put options) the asset at the strike price upon expiry.